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The Role of Organizational Scope and Governance in Strengthening Private Monitoring

  • Lamar Pierce

    ()

    (Olin Business School, Washington University in St. Louis)

  • Michael W. Toffel

    ()

    (Harvard Business School, Technology and Operations Management Unit)

Governments and other organizations often outsource activities to achieve cost savings from market competition. Yet such benefits are often accompanied by poor quality resulting from moral hazard, which can be particularly onerous when outsourcing the monitoring and enforcement of government regulation. In this paper, we argue that the considerable moral hazard associated with private regulatory monitoring can be mitigated by understanding conflicts of interest in the monitoring organizations' product/service portfolios and by the effects of their private governance mechanisms. These organizational characteristics affect the stringency of monitoring through reputation, customer loyalty, differential impacts of government sanctions, and the standardization and internal monitoring of operations. We test our theory in the context of vehicle-emissions testing in a state in which the government has outsourced these inspections to the private sector. Analyzing millions of emissions tests, we find empirical support for our hypotheses that particular product portfolios and forms of governance can mitigate moral hazard. Our results have broad implications for regulation, financial auditing, and private credit- and quality-rating agencies in financial markets.

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Paper provided by Harvard Business School in its series Harvard Business School Working Papers with number 11-004.

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Length: 58 pages
Date of creation: Jul 2010
Date of revision: Feb 2012
Handle: RePEc:hbs:wpaper:11-004
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